The first half of 2014 has seen a continuation of the bull market for equities that is now over five years old. Despite an economic contraction in the United States during the first quarter (much of which was caused by historically cold weather), the S&P 500 Index delivered solid returns. Meanwhile, the Canadian S&P/TSX Index outperformed the U.S. market for the first time in several years. This performance is likely unsustainable as it has been propelled by higher oil prices, caused by the crisis in Iraq and Syria. Hence, this outperformance is unrelated to the general state of the domestic Canadian economy.
If there is a dark cloud looming on the foreseeable economic horizon, it is the future of interest rates and their impact on fixed income investments. Over the past three decades, interest rates in the developed world steadily declined, boosting the value of bonds from both governmental and corporate issuers. This was a wonderful era for fixed income investors, as strong returns were made with relatively low risk.
Since the global financial crisis in 2008-2009, governments around the world have stimulated the economic recovery with aggressive fiscal spending, increased money supply, and a dedicated effort by central bankers to maintain interest rates at record lows. This scenario cannot last forever. Governments in some jurisdictions are already up against their borrowing limits. Argentina could be at risk of another default. Closer to home, Canada’s two most populous provinces, Québec and Ontario, have borrowed their way to the edge of their respective credit limits. While Quebec’s newly elected government has recognized this and is taking action to curb its spending, Ontario has taken a different tact, where it believes that it can still spend its way to growth. In our view, this latter strategy heightens concerns for the economic health of both Ontario and Canada.
Currently, global economies remain in recovery mode, with the considerable slack in employment and manufacturing capacity slowly being eliminated. As the economy moves to full capacity, central bankers will have to raise interest rates to temper economic overheating and the resultant return of inflation. Rising interest rates will do two things. First, they will materially decrease the value of fixed income investments, particularly those with longer maturities. Second, they will greatly increase the financial burden on governments, corporations and individuals that have borrowed too much and owe too much. Once again, Ontario and Québec come to mind.
Our strategy in dealing with this scenario is simple. First, we will only invest in short-term bonds and preferred shares, those maturing in the next two to four years. As these securities mature, and interest rates begin to rise, we will be able to replace them with new bonds or preferreds paying higher yields. Second, we will continue to emphasize investing in companies with solid growth prospects that have the ability to increase their dividends over time. Finally, we will continue to invest in equities across the North American spectrum, while keeping a wary eye on the growing deficit burdens in Canada’s largest provinces.